––– a weblog focusing on fixed income financial markets, and disconnects within them

Thursday, December 1, 2011

The Art of Pricing (and the Heart of the War)

The fight for transparency in the financial markets is gaining traction.

Even maverick Judge Rakoff, in his SEC v. Citi settlement ruling, got in on the act with commentary that resonates: “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.”

The recent media coverage on the transparency issue is particularly acute as it pertains to asset pricing transparency, which is becoming ever more important as the market seeks alternatives to ratings-based capital allocations, per the requirements of Dodd-Frank.

The problem is that while each asset has only one rating (from each rating agency), there’s no consistency of pricing from one bank to the next. We fear that absent a centralized or standardized solution, any mark-to-market pricing will continue to cause headaches in markets where assets aren’t actually traded (there’s no ready or visible price).

Floyd Norris explains in a recent piece that “[under] the [accounting] rules, banks have a choice of three ways to report the value of identical securities. Even if two banks are using the same valuation method for the same security, they can come up with different values, and it is very difficult for an investor to get any feel at all for just how optimistic, or pessimistic, a bank’s estimates might be.”

He also brings in a quote from former FASB member Ed Trott, explaining that “’we are moving back to the past’ by increasing the ability of banks to massage their numbers as they wish.”

This revelation (unfortunately) jibes well with Gretchen Morgenson’s commentary in her piece entitled Slipping Backward on Transparency for Swaps. Gretchen explains that “[right] now, many swaps are traded one-on-one, over the telephone. The price is usually whatever the dealer says it is.” (Recall in Michael Lewis’ The Big Short, when Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”)

And the problem isn’t limited to the comparability of asset valuations at the Big Banks. The Big Auditors are also coming a cropper in their audits of banks. Norris explains in a separate piece that analyzes the PCAOB’s oversight reports of KPMG and PricewaterhouseCoopers: “[one] virtually identical criticism of the two firms could be a sign of the way all the firms have been auditing how banks value hard-to-measure financial assets.”

“In three of these audits,” the board wrote in its report on KPMG’s audits done in 2010, “for certain financial instruments the firm obtained multiple prices and used the price closest to the issuer’s recorded price in testing its fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices.”

With the banks being able to extract greater margins from opaque markets, the war over asset price transparency is currently being won by the might-makes-right team.

But a more simple solution that levels the playing field for investors big and small, and reduces the burden (and cost) of each auditor having constantly to reinvent the wheel, is to create a central platform for pricing.

Confidence will increase in the adequacy, verifiability, and consistency of financial statements. Regulators would have a field day and investors would be better able to spot when they’re being fooled. Of course the Banks wouldn't be too happy.

Here’s an analysis we put together of the material benefits afforded by a centralized (and perhaps standardized) pricing solution.

Update Dec. 2: According to a Bloomberg article by Jesse Hamilton that came out this morning (SEC’s Data Crunchers Find Red Flags Leading to Hedge-Fund Cases), the SEC through a prorietary tool, has been increasingly been taking action against hedge funds for misconduct including "fraudulent valuations and misrepresenting fund investors."

“Hedge-fund managers depend on valuation and performance for both their compensation and marketing,” ... “These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”